China's Failure to Cool Economy Poses Threat

INVESTORS, EAST AND WEST, ARE EBULLIENT, although they should be agonizing in the face of the subprime meltdown in the U.S., overheating in China and a potential slowdown in world growth. While the Dow has been marching to a new high, Chinese shares have snapped back from a scare several weeks ago.

Against that backdrop, China last week reported that first-quarter growth in gross domestic product accelerated to 11.1%, from 10.7% in 2006, and that inflation was jumping -- a worrisome development; rising inflation was one cause of the Tiananmen Square demonstrations in 1989. Markets twitched, then settled.

That China clearly hasn't succeeded in containing growth should be cause for concern. "We can be pretty sure the real figure is way in excess" of reported growth, wrote Jim Walker, CLSA's chief economist. "The Chinese government has a huge task ahead to stop a massive blowout of the economy."

In the past year, China has already boosted bank-reserve ratios seven times and increased domestic-lending rates four times. But Morgan Stanley economist Stephen Roach points out that bank-reserve requirements are still at just 10.5%. Short-term rates are more than a full percentage point higher than a year ago, but are still just 6.4%.

Party On: Asia shared in the global bull run last week. Japan, Hong Kong and Australia all rose.

China has kept credit easy because it needs to print yuan to buy dollars to maintain its currency peg. That flood of liquidity is keeping the party going. Citigroup's Lan Xue reiterated her bullish call on Chinese stocks, forecasting 20% earnings growth this year for Hong Kong-listed Chinese shares.

The Financial Times reports that Chinese retail investors opened more than a million stock-trading accounts last week, or 10-million-plus over the past four months, greater than the previous four years combined. "It's great to be a broker," boasted one, eagerly anticipating his bonus.

At the same time, the Bank of Japan has bought dollars hand-over-fist to keep the yen cheap. That also keeps rates low, fueling the yen-carry trade and prodding Mrs. Watanabe to buy foreign assets. Japanese individuals, though often perceived as risk-averse, have been buying practically every market but their own -- suggesting a bubble of epic proportions.

True, U.S. investors bought only $5.2 billion of Chinese equities last year, a 10th of their purchases of emerging-market stocks. Yet China, Bank of America's Joe Quinlan observes, pumped $105 billion into the U.S. last year. "Any adverse economic event in China that cuts the financial umbilical cord connecting the mainland and the U.S. could prove quite dramatic for the world's largest debtor nation," Quinlan wrote. And if global demand is weak, the Chinese could be heading for a glut of goods that will bode poorly for corporate China and everyone else.

Foreign-exchange reserves are also soaring because corporate China is swiftly repatriating cash from its overseas IPOs to take advantage of expected renminbi appreciation.

Only last week, Beijing-based China Citic Bank (ticker: 998.Hong Kong) raised $3.7 billion in Hong Kong and $1.7 billion at home in the world's biggest stock offering this year. HSBC economist Qu Hongbin thinks that a 10% revaluation of the yuan and more aggressive rate hikes are possible.

Easy money means emerging markets will stay popular. Last week, Banque AIG Financial Products launched a tradable index on emerging-market currencies. Stephen Gilmore, who oversaw the index's construction, touted its benefits. "This has a very low correlation to emerging bond markets," says Gilmore, and emerging-market currencies, over the long haul, have returned 12% a year. Adjust for risk, he says, and the return is even higher.

THE NEW ZEALAND DOLLAR, a carry-trade beneficiary, set a 22-year high last week as rising prices are pressuring the central bank to tighten credit. Today, says Bernard Connolly of Banque AIG, the Kiwi is "extremely overvalued....It's the carry trade that keeps it going."

Even so, some see value in Kiwi equities. One fan is William Buechler of La Jolla, Calif.-based Barclay Partners. Buechler is enthusiastic about stocks, given the July debut of the KiwiSaver pension plan: "The Australians had a mandatory savings system with 20 million people, and now have $1 trillion or so in savings. It's not mandatory in New Zealand and the population is only 4.5 million" -- but the potential demand for shares is obvious.

New Zealand stocks are up 3.1% this year in the local currency, 9.6% in U.S. dollars; the comparable 12-month numbers are 13.7% and 35.6%. They trade at 19.4 times trailing earnings and yield 5.96% -- a level unseen in the U.S. since the '80s. The Standard & Poor's 500 trades at 17.7 times earnings, and yields 1.77%.

Buechler is fond of Fletcher Building (FBZ.New Zealand), "involved with virtually every residential piece of construction inside New Zealand and paying a 7% dividend," as well as Auckland Airport (AIA.New Zealand).

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